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Risk Aversion and Risk Opportunity

  • 2017 College Interns
  • 2017 College Interns
  • Risk is a natural measurement. We can determine the amount of risk involved in switching lanes of traffic when driving, the amount of risk in eating fast food regularly, even the risk of using your phone too much. I’d like to call it natural, not only because it comes with every decision we make in life, but oftentimes it’s a measurement that we don’t put a second thought into considering.

    This isn’t the case in the process of capital budgeting. It isn’t the case in the world of finance in general, because not accounting for the potential losses that come with reckless risks can severely undercut a company’s performance. When a company is making a strategic decision, risk is evaluated in terms of potential returns.

    Risk and return are directly related. If there is a decision between an easier choice and a harder choice, we are more inclined to pick the easier choice, because there is less risk associated with it. But, there are those who are willing to take on additional risk. They go for it because they have the chance to increase their profit, or their return on capital, far more quickly than those who decided to play it safe.

    That doesn’t mean that taking the riskier option is always necessary. When anyone takes on a riskier choice, they should not immediately expect it to be successful. In capital budgeting, companies will take these risks when they decide to replace outdated or broken equipment. They evaluate the financial risks associated with buying a newer and more expensive version, instead of replacing it with what they had before. They make a prediction on how much they could profit from it if successful, and make a decision based on the best option suited for them and their long-term needs.

    The stock market is the easiest way to visualize this theory in practice, and one of many ways that you can apply this principle to your life outside of work. If you decided to start investing in the stock market, you have the option to pick safer investments, such as government bonds. These are practically guaranteed to be paid off and provide you with interest, but will only return a small profit. Compare that to an investment in a technology company with a small market cap. There is the opportunity for you to make a much larger profit from them, but it’s less likely that it will come to fruition.

    It ultimately depends on your risk tolerance. Most people would prefer to choose risk aversion over risk opportunity, because some can’t handle the fear of failure, the fear of losing money, or losing time because they made the wrong choice. My suggestion: take that opportunity. The most successful people in the world are the ones with a high risk tolerance. They’ve failed several times, yes, but eventually they made a decision that succeeded, and opened a world of new and exciting experiences. If they can do it, so can you.